The breakdown of the traditional interbank market has resulted in a huge expansion of secured lending between banks channelled through non-bank financial intermediaries. The money holdings and borrowings of these intermediaries are included in M4 and M4 lending, which have been artificially inflated as a result.

This shift began well before the introduction of the special liquidity scheme (SLS) in April but it is reasonable to assume that most of the subsequent increase in intermediaries’ business with banks has been associated with lending secured on Treasury bills obtained under the scheme.

Between April and September M4 rose by £131 billion, of which £123 billion was accounted for by financial intermediaries. M4 grew by a further £43 billion in October, again probably largely due to intermediaries (no breakdown is available). This suggests SLS usage of about £165 billion by the end of October. This may be an underestimate, since the M4 numbers exclude business channelled through foreign-based intermediaries.

No sectoral analysis is yet available for M4 in October. However, the provisional release contains a split between “retail” and “wholesale” M4, with the retail component approximating to money holdings of households.

Inflation-adjusted retail M4 leads retail sales and overall consumer spending – see chart. Its annual growth rate fell to a new low in October, though has not yet turned negative, as it did in the early 1990s. An optimistic interpretation is that consumption is unlikely to be as weak as during the last recession. However, this is of limited comfort: spending fell in six out of seven quarters in that recession, with a peak-to-trough decline of 3.3%.

Monday’s Pre-Budget Report will be accompanied by a revision to the Debt Management Office’s financing plans for 2008-09. The DMO could support broad money growth by cutting planned gilt issuance and boosting sales of Treasury bills. Unfortunately, there is little sign such action is being contemplated.

When the authorities fund a budget deficit by selling gilts to the non-bank private sector, there is no net impact on the money supply – the injection of funds due to the deficit is offset by a transfer of cash out of bank deposits to pay for the new gilts.

Treasury bills are more likely to be bought by banks than non-banks. When banks provide funding there is no transfer of cash out of deposits held by non-banks so the injection due to the deficit is reflected in an increase in the money supply.

Under current plans the DMO will sell £116 billion of debt in 2008-09, comprising £110 billion of gilts and £6 billion of Treasury bills. Gilt sales have totalled £74 billion in the year to date, implying a further £36 billion by the end of March. The £116 billion full-year target is likely to be raised next week, reflecting a higher official forecast for public net borrowing. Suppose funding of £50 billion will be required over the remainder of 2008-09. If the DMO were to raise this amount by selling Treasury bills to banks rather than gilts to non-banks, broad money – measured by adjusted M4 (i.e. excluding deposits of financial intermediaries) – would expand by about 3%.

Annual growth in adjusted M4 was just 3.7% in September, according to the Bank of England (see chart 1.3 on p.11 of the November Inflation Report). On reasonable assumptions, a rate of increase of 6-8% per annum is compatible with achievement of the inflation target over the medium term. Replacing gilt issuance with Treasury bill sales over the remainder of 2008-09 would offset the impact of credit weakness on monetary growth, reducing the risk of a future inflation shortfall.

Economic models are prone to break down under extreme conditions. My MPC-ometer did not forecast the 150 bp Bank rate cut in November but it did indicate a larger reduction, of 75-100 bp, than expected by most economists - see here.

The December forecast will depend importantly on consumer and business survey results released around the end of the month. However, based on current information, the model suggests a cut of no more than 50 bp. A significant minority of economists expects a larger move, according to a Reuters poll conducted last week.

One property of the model is that the data hurdle for policy easing becomes higher as the absolute level of rates falls. Other factors holding it back from predicting a larger move are the recent further slump in the exchange rate and the MPC’s tendency to concentrate action in Inflation Report months.

Minutes of the November meeting released today indicate the MPC believes a further cut of more than 50 bp is warranted by the Inflation Report projections. However, these projections are subject to revision to take account of the fall in sterling (currently 6% below the level assumed in the Report) and fiscal loosening to be announced in the Pre-Budget Report. In addition, some MPC members argued that staggering a further reduction could help to support confidence as the economy weakens.

G7 three-month LIBOR – a weighted average of individual currency rates – has fully reversed its September / October spike and is now below levels prevailing before Lehman failed. 10-year interbank rates are also at a new low – see chart.

Less encouragingly, the fall in LIBOR has been entirely due to actual and expected cuts in official rates, reflected in a large decline in overnight indexed swap (OIS) rates. LIBOR / OIS spreads remain significantly higher than in early September.

The lower absolute level of rates will support the economy, partly by boosting the disposable income of borrowers whose loans are tied to LIBOR or policy rates. However, banks’ continuing difficulties in raising wholesale funds, reflected in high LIBOR / OIS spreads, will constrain the supply of new credit.

As argued previously, policy-makers need to shift emphasis from official rate cuts to direct measures to boost money and credit, such as underfunding budget deficits, buying private sector assets and guaranteeing lending to firms and households.

Incentivising Northern Rock managers to run down its mortgage book at maximum speed never made sense in a wider financial and economic context – as argued here.

According to the Sunday Times, the government is now seeking Brussels clearance to delay further repayment of the Treasury loan, implying Rock will offer more attractive refinancing terms to its borrowers in order to keep their business. The new approach would presumably extend to the Bradford and Bingley mortgage book.

The article also suggests that the final Crosby report next week will propose a government guarantee scheme for mortgage-backed securities. This could further loosen mortgage supply – but only if the fees are set at a significantly lower level than for the existing credit guarantee scheme.

Let’s see if these reports are confirmed.